A Close Look At The Volatility Index
AUDIE CORNISH, HOST:
The trouble in China was part of what shook U.S. markets this week. Wall Street started the week in free fall. The Dow plunged a thousand points when it first opened on Monday. Something known as the fear index captured the shockwaves rippling across the market. Robert Whaley is a professor of finance at Vanderbilt University. He created the VIX, or vix. That's the volatility index for the Chicago Board Options Exchange.
Welcome to the program.
ROBERT WHALEY: I'm glad to be here.
CORNISH: So what exactly does the VIX measure? How do you measure fear?
WHALEY: Through the price of insurance. The analogy that I often use with respect to the VIX is suppose you owned a vacation home on the coast, and you're worried about storms over the next, say, month. You look around at available information, weather forecasts, and suppose you decide that it's not very likely. You won't pay very much for insurance in that particular instance. On the other hand, if you find information that indicates it's going to be very stormy, you'll pay a lot more for insurance during that same interval of time. VIX is the same thing. Rather than protecting your house, however, what you're doing is protecting your stock portfolio. If VIX goes up, that means people are nervous about what's going to happen to the value of their stocks. If VIX is at a low level, they're not concerned. And so what you saw is that people panicked over the weekend probably based on the Chinese news. There wasn't much else happening. They overreacted, and to protect the value of their pension funds or whatever, they went out and bought insurance.
CORNISH: The VIX is a favorite financial indicator for people who want to read the market and market anxiety. But is it a forecast of kind of where investors are headed, or is it a mirror of what they're already feeling?
WHALEY: It's a forecast. It's not simply a mirror. It's your prediction of over the next month of how much noise there'll be, variability in the stock market.
CORNISH: Has it been wrong?
WHALEY: Oh, of course it's been wrong - going back to the weather forecasts, they're usually wrong. But based upon all the information they have, they make a prediction of what's going to happen. That doesn't mean it's going to come true, and the VIX is completely analogous to that.
CORNISH: So what does the current level of the VIX tell us about the future outlook of the stock market now?
WHALEY: A good way to think about it is using a benchmark of about 20. Twenty is the historical level of the VIX. So what you're seeing now at a level of like, 27, it indicates that investors are a little nervous, more so than they were a week or two ago. But I would look to that level to come down even more, back down towards 20.
CORNISH: In what ways do people misuse or misread the volatility index?
WHALEY: They don't understand it fully and they think it is a predictor and if it gets too high a level, the stock market crash is going to happen. Dispelling them of that notion is a little difficult sometimes.
CORNISH: I ask 'cause over the years, you know, it comes to be something that's quoted in news stories, right? And in a way, it ends up contributing to the ongoing story of the market of that week...
CORNISH: ...And I didn't know if there were times when you thought, jeez, this is not what I intended.
WHALEY: (Laughter). Yeah, it's a little problematic in some sense. But if it goes to a high level, there are a lot of people out there that are fundamentally concerned of a large stock price drop.
CORNISH: For you, you know, what scares the father of the fear index?
WHALEY: Not having a pension (laughter). I monitor VIX very closely, and right now I'm really not that concerned. I'm more in equities than I am in bonds. But if it gets to a high enough level, I'm going to have to realign that.
CORNISH: Robert Whaley is a professor of finance at Vanderbilt University. He created the volatility index known as VIX.
Thank you so much for speaking with us.
WHALEY: Thank you.
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